Unlocking the mystery of building trading strategies

The exact process of develolping a trading stategy differs based on the logic and complexity of the system; however, a general approach to converting an indicator into a strategy is to:

Define a basic trading strategy (this is based on observation)

Add filters to improve performance

Add rules for exits and position sizing

Optimize the variables, using both observation and strategy performance reports to measure results

Backtest using in- and out-of-sample historical data, and forward-performance test using live data to determine correlation (if the results are not correlated, it needs more work)

Trade the strategy, starting small and increasing position sizing only after the system has provided consistent results

A trading strategy starts with observation. A trader might observe, for example, a particular pattern in the market that seems to lead to potential trading opportunities. In “Creating custom indicators” (May 2013), we noticed that trading opportunities such as price and volume diverge and converge on the daily chart of the S&P 500 exchange-traded fund. In the article, this trading idea was converted into a technical indicator — the Volumizer — to evaluate the relationship between price and volume. The Volumizer plots the 40-day average price and 40-day relative average volume, allowing us to visualize differences between price and volume. The volume-price crossovers appear: